The Quarterly Earnings Game Is Far Crazier Than You Could Ever Imagine

A fascinating new study exposes the topsy-turvy world of corporate communication.

It comes four times a year: earnings season. For better or worse, shareholders, analysts, and the media breathlessly follow the latest corporate figures and news tidbits. Stock prices swing based on whether financial results match up to Wall Street’s expectations. It’s a high-stakes time for publicly traded companies.

With so much on the line, companies go to great lengths to portray themselves as well positioned, their managers straightforward and competent. Some techniques are well known, but much of the earnings game goes on behind the scenes, hidden from the public.

We now know a lot more about the sophisticated ways companies tell their stories thanks to a new research paper called “Managing the Narrative”. The survey, conducted by Lawrence Brown of Temple University, Andrew Call of Arizona State University, Michael Clement of the University of Texas at Austin, and Nathan Sharp of Texas A&M University, may be the first of its kind to study the people most responsible for managing corporate narratives: investment-relations officers (IROs).

The world of investor relations has transformed over the past several decades. No longer is it piloted by media-relations and advertising personnel grinding out empty PR and marketing copy. Today’s IROs work alongside the top executives at their companies, possess analytical expertise, and come from backgrounds in business, accounting, finance, and economics. This shift reflects profound changes in the ways companies communicate.

Professor Sharp, whom I interviewed about his work, told me that his team wanted to explore the inner workings of corporate disclosure. Despite all the research that’s been conducted on the personal styles and practices of CEOs and CFOs, academics know little about IROs. If we want to understand how companies communicate to the market, why they say what they do, and why the market reacts the way it does, we need to better understand the authors of corporate communication. So the professors surveyed 610 IROs and interviewed 14 to better understand how they work.

The paper contains a number of fascinating findings about the topsy-turvy world of corporate communication — in particular, how the theater of conference calls plays out, why analysts manipulate earnings estimates, and what really goes on in private calls between Wall Street analysts and the companies they follow.

I also think the study sheds new light on what the earnings game reveals about businesses, how smart the market is, and whether the playing field is truly level for all investors.

Do earnings surprises even matter?

First, let’s get one thing out of the way: It’s folly for long-term shareholders to focus much of their attention on whether a company beats or misses consensus analyst estimates. This might sound counterintuitive, but it’s true.

Investors profit by purchasing a stock for less than it will be worth in the future. That’s the case for growth and value investors alike — the various strategies are merely different methods for predicting future stock prices. It shouldn’t matter whether a company accomplishes what analysts expect of it; all that matters is whether its business outperforms what its stock price implies.

To put it another way, long-term investors don’t need to worry if “CatfudCorp failed to beat estimates by $0.01.” All that means is “analysts overestimated CatfudCorp earnings by $0.01,” which is trivial. No one would lose their head over a headline that proclaimed: “The weather failed to top consensus forecast of 56 degrees, falling short of meteorologists’ expectations by 1 degree. Time to panic.” Likewise, it seems investors can ignore the earnings-versus-expectations meta-story and pay more attention to real things, such as earnings growth, consistency, and stock valuation.

The best explanation I’ve encountered for the market’s obsession with forecasts has been entirely based in short-term trading dynamics: Momentum traders aren’t so much concerned with the absolute performance of a company; all they want to know is whether other traders will buy or sell a stock. They need to know what other traders will do, and a company’s beating or missing analyst estimates acts as a signal. It may be a largely arbitrary signal that doesn’t reflect investing fundamentals very well, but to traders, arbitrariness isn’t a big deal. All that matters is that everyone stays on the same page — an earnings beat means we all buy, and a miss means we sell. And since most shareholders are short-term-oriented due to a combination of psychological and institutional reasons, they’re sensitive to short-term price movements and feel the need to buy or sell along with everyone else.

This neat story helps explain why prices move on news of an earnings beat or miss — and why, for long-term investors, the whole spectacle is hollow.

Yet one tidbit in “Managing the Narrative” suggests that despite its intrinsic absurdity, the beat-or-miss dynamic can expose real information about a business.

Interviews with IROs show that many analysts are all too willing to sacrifice the independence of their forecasts to help management beat Wall Street’s estimates. Here’s how it works: At the start of each year, analysts tend to produce optimistic forecasts. Optimism endears them to management and helps purchase better access. But unbeatable forecasts don’t do the company any favors. And so, over the course of the year, analysts gradually “walk down” their earnings estimates to more realistic levels. Outperformance is one way to win the earnings game; lowered expectations are another.

Why are analysts so accommodating? It turns out that large shareholders, who don’t want a nasty earnings miss to tank their stock, can pressure them. Remember that the analysts who issue earnings estimates and stock recommendations are sell-side; they make income by selling research. Their clients are buy-side stockholders. And analysts want to keep their clients happy.

Multiple IROs explained how it works. Here’s an example:

What isn’t visible to the public is that buy-siders call up sell-side analysts all the time and chew them out. If there’s an outlier to the upside or the downside, they’ll often hear from people who are stockholders saying, “Hey, what’s with this number here?” I’ll tell you that goes on all the time.

Folks who own the stock will call up the analysts and beat them up and totally leave the company out of it. … If you own a stock, you’re aligned with the company. You want the results to be achievable.

Now we begin to see why missing estimates — even by a single penny — can produce what seem like silly overreactions. Management really doesn’t want to miss estimates. And apart from performing better as a company, they have a million well-known extramural tools at their disposal to ensure they outperform, from lowering guidance to all of the wonderful techniques of GAAP accounting manipulation. What’s more, analysts themselves face pressure from their clients to produce beatable estimates. So when a company still fails to beat estimates and can’t provide a convincing excuse, despite all the odds stacked in their favor, then that suggests they really screwed up.

The strangest part is this: Consensus earnings estimates may be an arbitrary, easily manipulated benchmark more useful to momentum and short-term traders than to investors. Yet despite their arbitrariness — and in fact precisely because of their manipulability — the inability of a company to beat estimates can paradoxically reveal real information.

Earnings calls: “a bit of kabuki”

Once a company has announced quarterly earnings results, it’s time to host a conference call. This event gives management a chance to tell its story to the public, and it gives analysts a chance to ask clarifying questions and probe management on topics it would rather avoid.

At least that’s how things appear on the surface.

As it turns out, neither the story, nor the questions, nor the answers to those questions are quite as real as they appear.

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Conference calls begin with management’s summary of key facts about the quarter in prepared remarks. They’re primarily delivered by the CEO and CFO, but IROs plan the narrative, and some IROs even write the entire script.

The question-and-answer portion seems much more unplanned, but it, too, can be highly choreographed.

For starters, the questions sell-side analysts ask aren’t always their own. As it turns out, buy-side analysts often feed them questions in real time to ask management.

Why would buy-side analysts need sell-siders to ask questions on their behalf? Buy-side analysts typically never participate in conference calls. To ask a question in public would be to reveal your thinking about an investment to other traders. It would be as stupid as thinking out loud at the poker table.

But a neat trick gives buy-side analysts a chance to participate, albeit indirectly. They can use sell-side analysts as a cipher:

The sell-side analysts are sitting there with their IMs [instant messengers], and they’re IMing the buy side. The buy side is texting them saying, “Ask them about X, Y, and Z,” or “That last answer was BS; push them on this again.’ The buy side doesn’t want to be on the call and show anybody their cards. So the whole thing is kabuki.

Management plays a part in the mutual Q&A facade. Companies go to great lengths to prepare answers ahead of the questions:

I literally, on my laptop, type up every question that [has been] asked [during previous calls]. Then I code them by category. … I track trends and investor concerns and investor likes by doing that. … [Then] my senior management and I discuss potential questions and prepare for them. I can’t think of a time when we’ve been broadsided.

It’s even common for IROs to ask analysts what kinds of questions they should prepare for. Shockingly, 40% of IROs said they actually exchange private phone calls and emails with analysts during the time between an earnings release and the conference call:

What you’ll learn is what is creating confusion, what don’t they understand, what needs more clarification, what are the hot-button topics. It gives you better insight into what’s likely to come up on the call, and you’ll be in a position to give better answers.

Private communication before the public call also gives companies a chance to influence what questions they’ll get asked:

The company can talk to the analysts at that point and basically guide the analysts to help manage the public call. … If I can call some of my investors or analysts before the public call, then the analyst doesn’t ask me a really tough, embarrassing question in public.

That some companies would be communicating with analysts between an earnings release and a conference call is prima facie shady. Remember, this is an extremely sensitive time. Institutions are hastily buying and selling shares on the basis of limited information contained in the earnings announcement. More feverish trading continues, during and after the conference call, as the market processes fresh information. Anyone with early access to whatever timely information or clarification is going to be presented during the call would be in a position to out-trade competitors.

While the practice is by no means universal, and many IROs said they’d never engage in it, it’s amazing to discover that so many companies do.

VIP access: Who’s the patsy?

It’s obvious that analysts would value private access to management. Now we know that private calls are useful for companies, too. More than four out of five IROs said their company conducts private phone calls with analysts. And two-thirds said private calls were “very important” to communicating their message — an even higher rate than said 10-Q and 10-K filings were very important.

What do analysts and management discuss in private? Since October 2000, it’s been illegal for companies to share material information in a non-public setting because of a rule known as Regulation Fair Disclosure. By allowing every investor, big or small, equal access to information, Reg FD has been one of the great democratizing rules of the market.

So why do analysts and IROs place so much value on private calls with one another if they’re not allowed to talk about anything material that hasn’t already been disclosed? Another way to put the problem: It looks like someone is being taken advantage of. So who’s the patsy?

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As I see it, there are four candidates:

Sell-side analysts and their clients. Private calls amount to little more than PR spin.

Clients of sell-side analysis. The information companies share on private calls is analytically useless, but the allure of exclusive access to management enhances the prestige of sell-side analysts for marketing purposes.

Everyone else. Companies selectively share critical information with some favored institutions, giving them an unfair advantage over other investors, possibly in violation of Reg FD.

No one. No material, non-public information is given, but the calls aren’t totally useless. They give companies chance to clarify misunderstandings and correct errors, helping markets to process information and price stocks more efficiently in a way that’s fair to everyone.

So which is it? Probably a bit of each.

No doubt communicating a company’s message involves some mix of truth, management’s take on the truth, and a sprinkling of what management is hoping to get the market to believe. It’s not usual for management teams to put on a positive spin during public conference calls, so we should expect that they would do the same in private conversations.

Investors need to trust the person who is in investor relations. You’re the front line of defense. … You have to be able to talk intelligently, talk rationally, without emotion, about what’s happening, whether it’s good or bad.

Their professed objectivity is backed up by multiple other survey responses. For instance, IROs say the most useful people to talk to are experienced analysts — precisely the people who would theoretically be in a better position to detect corporate dissembling. We also know that overly optimistic analysis doesn’t help management, since unrealistic expectations only raise the earnings bar. And elsewhere in the paper, we find out that IROs don’t contact analysts at a much higher rate to discuss downgrades than they do to discuss upgrades.

Running a big company is like watching sausage being made. It isn’t easy, it isn’t pretty, and a lot of times it’s better not to know what goes into making the sausage. … When something goes wrong, basically what investors want you to do is acknowledge it, be forthright with what’s occurred, and give them at least a sense of a get-well plan. … What they hate more than anything is being deceived. “Don’t tell me everything is wonderful and great and then show up on the earnings call and puke.”

Taken together, it seems IROs try to put their best foot forward but mostly avoid spinning analysts outright. But there’s also good reason to believe analysts value private calls for reasons other than gathering information.

In a previous study by the same authors, analysts revealed that their compensation wasn’t driven by the accuracy and profitability of their reports, stock recommendations, or earnings forecasts. But their relationship with management and industry knowledge, which provides access to management, did mean a lot.

That’s probably because their institutional clients crave access:

If I call up a money manager, a hedge fund, whoever, and I’ve got a call to make on a stock, and I’m able to say, “Hey, by the way, we were able to spend 20-30 minutes talking to senior management,” boom! Their ears are just straight up.

It seems that for analysts, the prestige of speaking to management is worth at least as much as are any insights they’re able to glean. Institutional investors want an edge so badly that they’re willing to pay up — even for the mere feeling of an edge.

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But just because private calls are a useful marketing tool, that doesn’t mean companies don’t share sensitive information on them. In fact, access to material, non-public information would enhance an analyst’s market value. How can we be sure special access for analysts doesn’t put the rest of us at a disadvantage?

“Managing the Narrative” asked IROs about this issue. As you’d expect, IROs say that they scrupulously follow Reg FD. And they score a nearly perfect track record of compliance in spite of analysts’ best efforts to get information they’re not supposed to have. One-fifth of IROs said analysts ask for information banned under Reg FD “several times a week or daily,” more than half said it happens several times a month, and 93% said it sometimes happens. Yet a whopping 72% said IROs “never” answer a question without fully considering Reg FD ramifications. That’s an incredible record.

IMAGE SOURCE: “MANAGING THE NARRATIVE.”

Such a glowing report may not be entirely accurate, for several reasons. IROs, just like most people, are probably a bit reluctant to incriminate their profession to a surveyor. Self-deception could play a role, too — no one likes to believe his or her profession behaves unethically. Finally, there’s the epistemic elephant in the room: Absent the sort of feedback that analysts would never give them, IROs can’t possibly know how often they accidentally reveal too much, because part of the nature of making a mistake is to be — at least for a time, and often forever — unaware of your mistake.

Though the study tried to address these issues by asking IROs how often Reg FD issues crop up not for themselves but for the “typical IRO,” Professor Sharp agreed that we should probably take these Reg FD responses with a grain of salt. He suggested we might consider 72% a ceiling for how many IROs don’t share information they’re not supposed to — meaning it’s possible more than one-quarter of IROs share information they shouldn’t.

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Despite its limitations, communication isn’t the Wild West that it was before Reg FD. After all, more than half of IROs say they get asked questions several times a month that they refuse to answer because of the rule. So the study suggests Reg FD is doing a lot to keep investors on a more level playing field.

What legally innocent things do IROs and analysts discuss in private? Much of it is regurgitory. During earnings season, analysts are frantically updating their models, estimates, and recommendations on dozens of stocks — all at the same time, on little to no sleep. IROs say private call-backs during this busy time help them ensure frazzled analysts accurately remember information from the conference call.

Another lawful function of private calls: Reg FD allows companies to share information with analysts that’s critical to their research — even if it’s non-public — under certain circumstances. Suppose an analyst has everything he needs to assemble an opinion of the company except for one last fact. So long as that final puzzle piece would be immaterial knowledge on its own, it’s legal for the company to share the information even if it hasn’t been disclosed publicly. (This loophole doesn’t, however, let companies disclose material information by subdividing it into tinier, non-material pieces in the same way the nutrition label on cooking spray rounds the fat content to zero by making the serving size infinitesimal.) So scraps of immaterial information can also be extremely valuable.

But the amount of hands-on support IROs provide analysts is astonishing. They actually proofread analyst models:

We look at analyst models and look for inaccuracies and look for areas where we would feel comfortable giving them feedback. … We reach out to those analysts who are far off the mark.

If you’ve ever been lucky enough to have a high school teacher willing to provide feedback on test questions while you’re still taking the test, then you understand how advantageous this could be:

Typically a month out from earnings, we’ll get everyone’s latest models, and then we’ll go through them. If they modeled something incorrectly based on what we’ve said publicly, we’ll highlight the discrepancy.

One IRO admitted to some truly extravagant kibitzing:

We literally pour all their models into a spreadsheet. So if you’ve got 10 analysts, you’ve got 10 columns. And you’ve got rows for all your revenue lines, and you’ve got rows for all your expense lines. … [If] I see that an analyst has a couple lines that are just off, whether it’s revenue or expense, and I know that there’s something in the public that I can point to, I can help them rein in that line.

All this effort makes sense from an IRO’s perspective. Companies want analysts to produce realistic forecasts so that they can beat the consensus estimate. Goofy as that motive may be, there’s nothing nefarious per se about fostering realism.

But this level of involvement with analyst models does seem to violate the equal-opportunity spirit of Reg FD. And access is certainly unequal. In addition to favoring experienced and knowledgeable analysts, IROs are more likely to grant access to large investors than to the press by a 4-to-1 margin.

IMAGE SOURCE: “MANAGING THE NARRATIVE.”

Practices such as conducting private calls and offering finely tuned feedback on models certainly put information on a less even playing field.

The smartest analysts in the room

When it comes to which analysts IROs prefer dealing with, the most important factors are an analyst’s experience covering the company and industry knowledge. This fact may seem obvious or insignificant, but there’s a lot we can infer from it.

IROs say they are much more likely to grant experienced and knowledgeable analysts private phone conversations, the right to ask questions on quarterly conference calls, and that most coveted and precious resource: access to management.

What’s so special about knowledge and experience that trumps all other qualities, including brokerage size, awards, underwriting business, and media exposure?

IMAGE SOURCE: “MANAGING THE NARRATIVE.”

I imagine IROs prefer more experienced and knowledgeable analysts because they think these are the analysts who can amplify the corporate message accurately and loudly.

Accuracy is obviously important: If you’re an IRO, and your job is to get analysts to spread your message far and wide, you don’t want to waste your breath on some neophyte who will spew imprecise or false information.

In addition to accurate, you also want your megaphone to be loud, in the sense that when an analyst speaks, the market listens. The loudness criterion suggests that, apparently, institutions are smart enough to listen to analysts with the most knowledge and experience, rather than getting their information from the largest or most popular brokerage, or from those with lots of media exposure. At least that’s what IROs seem to think.

If we assume IROs are correct to privilege experience and knowledge for their loudness and accuracy, we learn two important things: First, the market does at least a decent job paying attention to insightful analysts over less insightful ones — otherwise, experience and knowledge wouldn’t indicate loudness. And second, those of us who pay attention to sell-side research might also want to focus on experienced and knowledgeable analysts over name brand, since they’re the ones with the most accurate and precise information.

Long experience following a company is important for understanding context:

There’s a lot of value to people who’ve been covering you through different cycles. … Someone who’s a year into it is less likely to immediately recognize some of the little changes in the market environment that can really turn the fortunes for a small sector or group of companies.

The flow of information goes both ways. IROs and management may know a lot about their company, but they don’t always have time to keep tabs on everything that’s going on in their industry. Analysts are the mirror opposite. They know a lot more than IROs do about the competitors and industry trends, but they need help getting company-level insights. So IROs share company-specific information with analysts, and analysts share industry-level information with IROs.

IROs did seem to hold two methods of communication in special contempt. In question after question, IROs described media and social media as relatively useless for communication purposes. Just 10% said the press was very useful for them to do their job — though female IROs seemed to find the press more useful than male IROs did.

The reason for their disdain? IROs think of the press as a loud megaphone, but not a very precise one:

It’s an opportunity to reach a very broad audience, in some cases millions of readers, but it’s not a good opportunity to really tell your story in detail. There just isn’t enough time and there isn’t enough ink to really do it justice.

Social media is even worse — not only is it imprecise, but it’s not even loud:

The investor community largely ignores it.

It’s not well suited [for investor relations], and one of the main reasons is that stories are often complicated.

If there are any takeaways for the media in all this, it’s that there may be an opportunity to improve coverage by paying close attention to the sources IROs trust — sell-side analysts with long experience covering the company and extensive industry knowledge. Also, social media can tell us what topics people are interested in, but the information it presents is woefully simplistic.

“Thanks for the extra color around those assumptions”

From hidden meaning in hollow metrics, to the weird brew of information, PR, tips, and marketing solutions on private calls, to doctored estimates, staged questions, and staged answers, we’ve learned a lot more about the ambiguous nature of information on Wall Street.

There are still many more questions to be answered, particularly in the area of Reg FD compliance and whether IROs’ coziness with analysts creates an unfair advantage for other investors.

“Managing the Narrative” is packed with fascinating data about how companies package, market, and distribute financial news. Understanding the epistemic quirks it records can make us all smarter consumers of financial information. I’d strongly encourage everyone to read it — investors and journalists alike.

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